Price/Earnings (P/E) is probably the most most favored valuation ratio amongst investors. Any serious discussion of earnings would definitely involve the P/E ratio. This ratio numerically represents the relationship between a company’s stock price and it’s earnings. It helps serve as a measure of whether the stock is overpriced, fairly priced, or underpriced, relative to a company’s earnings per share (EPS). EPS represents how much one share of stock has earned over a set period of time. EPS can be taken for the full year, the last few quarters or it can be taken from the earnings expected in the next few quarters.
The P/E ratio serves as a good indication of how much investors are willing to pay for a company’s earnings. Higher the P/E, more the investors are willing to pay for each stock of that company. Investors tend to be willing to pay higher for companies that show high growth rates. The P/E ratio helps understand how expensive or cheap a stock is. However, a P/E ratio by itself is of little help. The most useful way to use a P/E ratio is to compare it with a certain benchmark. A good reference benchmark would be the average P/E of other companies in the same industry.
All else equal, a company that has better growth prospects, lower risk and lower capital reinvestment needs than it’s industry peers should be rewarded with a higher P/E ratio. However, renowned investors such as Warren Buffett hunt for stocks with a low P/E ratio, for the simple reason that such stocks denote little or no price appreciation despite having strong or steady earnings, which reflects an underpriced scenario and signifies a buying opportunity. The P/E ratios are an extremely effective tool for making apples-to-apples comparisons of similar companies whose stock prices happen to vary.